Roger M. Kubarych, a CFR senior fellow for international economics and finance, says the February 27 plunge in global share prices in large part reflects concerns over the highly leveraged state of world markets. Kubarych, a former chief economist at the New York Stock Exchange, said the plunge could restrain flows of credit, noting some already-announced restrictions to risky mortgage lending in the United States. “This real electrifying drop in the stock market will really have an impact on consumer sentiment when they've been a little bit too exaggeratedly confident,” says Kubarych.

What happened to cause the sell-off?

There are three reasons for this big sell-off in global stock markets: First, the Chinese [indicated] they were going to basically come up with something like margin requirements to curb the borrowing power to buy stocks on a leverage basis. That certainly was a major factor, a major triggering factor. I think it's probably worth about half of what happened. But the other half is divided up into a couple of other themes that are very important.

Could you just elaborate?

We have margin requirements in the U.S. They've been at 50 percent forever. The Fed [U.S. Federal Reserve] under [former Chairman Alan] Greenspan never liked to change them and basically rejected their impact. That's been proved wrong. Just the talk of greater constraints on borrowing in order to buy stock has potential to deliver quite big impact, at least in China. And they may do other things. They may do nothing now, but clearly the idea that you could no longer borrow money to buy stock would really upset a lot of strategies. That's the heart of it.

You said there were the two other reasons for the market plunge?

There was a general concern about what you might call risk taking. There was sensitivity in the market to the possibility of something going wrong to dislodge this enormous lack of risk aversion. So all kinds of assets, whether it's emerging market debt, emerging market stocks, stock markets in Europe and Japan, in Singapore—Singapore is still up 8 percent year to date despite the fall of yesterday —there were some really big plays on stock markets in a lot of countries.

We're talking about indicators that clearly show that people should be more cautious?

A lot of people are saying, “Look, the markets are very resilient, they've taken a lot of shocks all in stride, starting with [the collapse of] Amaranth [U.S. hedge fund Amaranth Advisors LLC], the Thai coup, the start of this problem in the U.S. sub-prime mortgage market [lending that involves higher credit risks]. So what's the worry? We're just going to keep doing this.” But it becomes a background factor. So more and more people were looking at how highly leveraged different markets had become. That's factor number two, and I think that's about 25 percent of it. In other words, a new mood of awareness that the markets were highly leveraged, which leads people to be very trigger happy if something changes.

The third factor was a bunch of data that suggested that maybe the Fed's rosy view of the economy wasn't accurate, and that maybe there are greater downside risks. One of the factors was Greenspan's comments that were widely broadcast, maybe unfairly to him, because he said some calming things as well. But when he says yes, there is a possibility of a recession by the end of the year, it's so specific that it really gave it credibility, rather than just a hypothetical. So it didn't come across in a neutral way. It came across as that he wanted to call attention to risks of recession, which is totally different than everything the current Fed officials are saying.

So that speaks to his stature as well.

His stature, his track record, and so on. Also that got reinforced by yesterday's durable goods orders, which were really ugly. Big drop, 7.8 percent drop in one month. A 60 percent drop in Boeing orders. But they had telegraphed in public statements weeks ago that that was going to happen.

So it was in the backs of people's minds, in other words.

More than that, it was in everybody's forecast. We were all forecasting a 2.5 to 3 percent drop in durable goods orders. It was 7.8 [percent drop in orders in January], but that difference was in core capital goods orders, excluding aircraft. That suggested business investment is not doing too well coming into the first quarter. And as you know, business investment in the fourth quarter of last year actually went down.

So basically nobody at the Fed has acknowledged that there are any problems with business fixed investment. Except if you look at the numbers it's been down two of the last three quarters, equipment and software, capital expenditures. So the durable goods orders were ugly. We all knew that the GDP [U.S. gross domestic product] number that just came out a few minutes ago [2.2 percent growth in 2006] would be lousy.

What does it say that it took this Chinese market reaction to set off everything else?

The Chinese reaction probably could have stayed in isolation if you didn't have all these other concerns about excessive risk taking.

Because that market is still pretty much closed off?

It's mostly a domestic market. Only a few hedge funds can slip in. There's a lot of control. It's not really an international market in the sense that Japan or Singapore is.

But it signifies a change in attitude. If it's true that they were going to do these things to prevent a boom or bubble—there was a boom. I mean they were up 80 percent since September, so there was definitely a lot of bubbling going on. Whether it's a bubble or not, that's linguistic. But certainly it was bubbling, and the notion that they might put some restraints on leveraging is certainly plausible and consistent with the kind of system that they run. They're much more willing to use regulatory tools than, for example, the Fed would be.

What impact are these trends in the U.S. economy, the world's great consumer, going to have on the rest of the world?

The consumer has still been spending like mad. The consumer is basically ignoring everything. The consumer in the U.S. has got a bigger and bigger negative savings rate. So they've been borrowing up to the hilt.

Today you may have seen Freddie Mac saying we're not going to buy any of this stuff [this debt—Freddie Mac announced tougher lending standards]. Well they shouldn't have been buying it in the first place. It was irresponsible of Fannie and Freddie to buy. Twenty percent of the new issues of mortgage-backed securities backed by sub-prime mortgages were being bought by Fannie and Freddie. Given their accounting scandals, and all of the management shake-ups and everything else, nothing should surprise you about Fannie and Freddie and how they're managed. But Dick Syron [Richard F. Syron, chairman and CEO of Freddie Mac] to his credit has said “well we're going to have to be a lot tougher.”

It is a story that has been there for everybody to see for months, I would say for over a year and a half. And yet, because of this exaggerated risk taking and absence of risk aversion, people have been saying “well, it's no big deal.” Well it is a big deal, and it means 23 percent of all mortgages have been sub-prime.

This so-called using the home as the ATM is going to be much more constrained?

Absolutely. This impact on housing through the sub-prime mortgages on credit availability, that doesn't happen over night. This strings out the adjustment to the housing collapse, and it really has been a collapse if you look at housing starts. It's very similar to other collapses in housing that we've had. This is not some small matter. This is a big deal, but it hadn't affected consumption because this credit engine had been still in place. But they're just taking one of the cylinders out of the credit engine.

You've got to look at both the appraisal of consumers' current situation and the future situation. Current situation appraisal is up. Job market's pretty strong. Gasoline prices are low and the stock market had been up. This real electrifying drop in the stock market will really have an impact on consumer sentiment when they've been a little bit too exaggeratedly confident. Now they're going to learn a lesson from this. We all are, including the Fed. The Fed's going to learn a big lesson. To ignore downside risks is to put yourself at risk. To really having these market shutters when the downside risks, which are always there, are made more apparent.

This is a phenomenon that's not just U.S.-based. It's international in terms of the risk?

The risk-taking has been international; these hedge funds operate internationally. The private equity funds operate internationally. If there are shocks to the credit system, it becomes more difficult to finance something like this TXU merger—or takeover, I should say.

These private equity deals have been a major prop under the stock market and those are all highly leveraged. The banks aren't going to be so free and easy in lending to these things if the risks are perceived to be higher.

What might we see happen internationally in reaction to these all these things you've laid out?

I think it'll make everybody a lot more worried about pushing too hard for a dollar depreciation to cure the U.S. current account deficit because of the risk that it could get a momentum that nobody would want to see. So it'll make people at the official level willing to live with this current situation without adjusting it. Without an adjustment mechanism, it's going to make legislatures—and particularly ours and the Europeans—much more receptive to protectionist arguments. They're going to say this isn't fair, nothing's changing, exchange rate adjustments aren't happening.

Right as they're discussing reviving the Doha rounds.

Well, the Doha round, they're going to put some Band-Aid on it. Some parts of it will go through. But it hasn't been a major issue for markets for quite some time. I'm not against the Doha round but it's never had the unbridled enthusiasm of the U.S. business community in the first place. Really there are only a few industries that see themselves benefiting a lot.

You're saying the general opening of markets is going to be chilled?

Yes, but on the other hand at the end of the day, the open-markets people have a very strong counter-argument. You put on protectionism and what you saw the other day will be much worse. To a certain extent it has been a useful brake on the protectionists actually getting things through. They will pull their punches because they don't want to be blamed for a big stock market rout. But what it means is that there won't be any adjustment mechanism for the U.S. current account deficit and it'll come close to a trillion dollars next year. So you still are counting on phenomenal inflows of capital from Asia and OPEC.

Anything else to point the way forward from the events of yesterday?

We've had many days that historically have been much worse. This is certainly nothing like 1987. But it's a big-time reminder that there are risks out there. When you're leveraged, your rates of return are spectacular when you're right, but you can lose a hell of a lot of money very fast when you're wrong. Hedge funds are better at bragging about the money they make than the money they lose.

It's certainly a huge yellow light, to go slower, to be more cautious. It's a reminder you can lose money owning things on a leveraged basis when the prices go down. That's the sort of summing-up line. In a certain sense it's useful to have days like yesterday, just to remind some of the Young Turks that they don't always make money easy.